A well-functioning financial system is increasingly important for economic development. This is not only the case for economies like ours here in Hong Kong where financial services constitute a substantial proportion of GDP, but equally for economies that rely on other sectors, be they manufacturing, mining, or agriculture, for the bulk of economic activity.
There are many reasons for this. First, a well-functioning financial system helps allocate capital to the most productive individuals, firms, and sectors through the process of intermediation between households that engage in savings and entrepreneurs who require funds to carry out investment projects.
Second, broad financial markets permit risk sharing and diversification, thereby reducing the exposure of investors to idiosyncratic risks.
Third, structured financial products allow the transfer of risk to entities that are most capable of bearing it. This makes it possible for economic agents to offload risks that they are not well equipped to deal with and specialize in activities which constitute their comparative advantage.
Last but not least, a financial system makes it possible to shift purchasing power across time as individuals build up financial assets while they are working to sustain a comfortable living standard in retirement.
Considerable progress has been made by many regional economies in revamping and strengthening
the financial markets since the Asian financial crisis. However, there is still a general lack of diversity
in the channels of financial intermediation, with a significant over-reliance on the banking system. In
spite of the brisk primary and secondary market activities in a few stock exchanges in the region,
capital markets, in particular the bond market, remain rather underdeveloped. There is much more to
be done, therefore, to further develop the financial markets by the regional jurisdictions.
The new frontier
Globalisation and the revolution in information technology have fundamentally altered the dynamics of
international finance. Such changing dynamics raise concerns among many of us about the manner in
which a sizable portion of gross savings in Asia finds its ways into financial obligations of the
developed markets before they are recycled back to Asia. As the capital inflows into the region tend to
be more volatile, the recycling process may have implications on monetary and financial stability in the
region.
Another aspect of the dynamics of international finance is contagion. World interest rates have
until recently stayed at record lows. In search of higher yields, hedge funds and other institutional
investors have scoured the world for assets generating higher returns, driving up asset prices and
driving down credit spreads.
As the interest rate outlook has become uncertain, fund managers may be reassessing the risks of emerging market assets, as reflected in the recent correction in world equity and commodity prices. A sudden exit of capital could leave those economies with weaker financial systems even weaker, with spillover effects on other parts of the region. All these developments highlight the need to explore and develop a new frontier of regional cooperation in Asia, particularly for the development and integration of financial markets, and build a bigger market to cope with the changing dynamics of international finance.
The development of deep and sound financial markets must start at home. Only the relevant
authorities within each jurisdiction have the ability to establish a regulatory and institutional framework
that will permit and encourage the growth of a vibrant private financial sector. All of us in the region
understand this and are working individually to improve our domestic markets, albeit from very
different starting points, which explains the differences that still exist among us in the size and
sophistication of our financial markets.
Integrated markets to withstand turbulence
But the development of the financial sector in each economy is limited by the size of our domestic markets unless we open our borders to international trade in financial services and the establishment of foreign financial institutions on our territories. Banking and finance are subject to economies of scale and scope, so the expansion of the effective market size is necessary to make the provision of financial services more efficient.
In addition to taking advantage of economies of scale and scope, the case for integrating financial
markets across jurisdictions is simply an extension of the case for developing the markets within each
economy. The gains from financial intermediation across jurisdictions, from international risk
diversification and risk sharing, and from access to financial instruments to fund pension schemes are
multiplied when we allow individuals, enterprises and fund managers access to each other’s markets
in addition to our own.
Clearly there is a case for linking markets together in order to be better prepared to withstand possible
turbulence in global financial markets. Speaking from experience, there is, I believe, other things being
equal, a non-linear relationship between vulnerability to financial instability and the size of financial
markets.
The very small financial markets are not attractive to international capital because of the lack
of liquidity and so there is little volatility generated by the inflow and outflow of international capital.
At the other extreme, where financial markets are very large relative to international capital, sudden
movements of the latter will only lead to ripples, which are not big enough to cause any financial-
stability concerns.
The most vulnerable financial markets, other things being equal, are the medium-
sized ones, which have adequate liquidity to attract international capital but which are small enough
for short-term trends to be dictated by large operators looking for short-term gains. Unfortunately,
many financial markets in the region fall into this category.
Of course, merely increasing the size of a financial market cannot be a substitute for sound
macroeconomic policies as a guard against volatile capital flows. Indeed, I believe that the authorities
in the region are committed to prudent monetary, exchange-rate, and fiscal policies. But I am also
convinced that expanding the effective size of Asian financial markets through greater integration
across jurisdictions, can make our economies better able to absorb the volatility of international capital
as effectively as the US and European markets.
Asian Bond Fund is a start
It is therefore heartening to observe that several initiatives for promoting the development of the financial markets in the region are bearing fruit.
A notable example is the Asian Bond Fund (ABF) initiative championed by EMEAP central banks. The ABF has been created specifically to encourage the development of bond markets in Asian economies, with the ultimate goal to create an integrated regional market. In developing the ABF, we have achieved a few firsts, including the introduction of the first exchange-traded bond index fund in Asia, arranging for two Asian markets to allow exchange-traded funds for the first time, and opening up the renminbi inter-bank bond market for the first time to foreign investors.
The process leading up to the launch of Asian bond funds has shown that cooperation between central banks in the region can successfully deal with a number of technical and conceptual issues, which bodes well for the further development of this initiative as well as potential initiatives in other areas of financial market development.
The successful experience of ABF has laid a strong foundation for enhanced regional cooperation by
central banks to promote financial integration in Asia. There seem to be at least three aspects in which
further development of central bank cooperation may be useful.
The first concerns the continuity of the research and discussion processes in the respective areas of central bank cooperation. Continuity helps keep track of the emphases and priorities of regional members and promotes effectiveness of the ongoing collaboration efforts.
The second aspect concerns the need to follow through cooperative initiatives that have been agreed upon by central banks in the region. The follow-through can be done effectively through intensified, and perhaps more conveniently organised, dialogue and information sharing.
The third aspect concerns the approach towards central bank cooperation. There are many areas of common areas of interest among regional central banks, including monetary and financial stability, payment systems and reserve management, to name just a few. In short, there is a need to organise central bank cooperation in a more focused, coordinated and dedicated manner in order to pursue our common interests.
Advances on these fronts will contribute to the overall gains from financial development through more
effective financial intermediation, more efficient risk sharing and risk management, and increasing
opportunities to make transactions between time zones smoother. Each requires modifications in
domestic regulations and institutions as well as significant coordination between jurisdictions. I believe
that progress in one area will be reinforced by progress in the others in a virtuous circle.